The upside of a down market

Find 4 ideas that may help you take advantage of falling stock prices.

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Key takeaways

  • Making regular investments through market downturns allows you to buy investments when prices are lower.
  • Rebalancing into beaten-down types of investments can help you manage your portfolio's risk level and be positioned for a potential recovery.
  • To make the most of a bad market, consider taking advantage of lower-cost investments through disciplined strategy.

For investors, a market pullback can be a painful thing—no one likes to see the value of their account go down. But every downturn comes with potential opportunities. One upside: While the investments you hold may be dropping in value, the investments you may want to buy could be getting cheaper. Also, some transactions may get more appealing when market prices fall.

As anyone who has been following the market knows, it is impossible to predict how long a market trend will last, whether prices are rising or falling. "Emotions run particularly high when markets fall, but savvy investors learn to rise above their fears and seize the opportunities that arise," says Ann Dowd, CFP® and vice president at Fidelity.

Here are 4 strategies for investors to consider to help find some upside in a down market.

1. Stay disciplined to seize opportunities

Some investors have a tendency to try to time the market in an attempt to avoid downturns and capture gains—but most are not very successful. History shows that, in aggregate, many investors often buy into markets near peaks and sell near bottoms. For example, there were big inflows into stocks in 2000 and 2007, just before market peaks, and dramatic outflows in 2008 and 2009, right before the market took off (see chart).

Instead of trying to jump in and out of the market, you can reality-check your investment mix to be sure it is still right for your goals and risk tolerance. Most investors have long-term goals, and plans built to work through ups and downs over time. If that's the case, it makes sense to keep a long-term perspective and continue to save and invest.

Consider a dollar-cost-averaging strategy by putting a set dollar amount into a portfolio each month. While dollar-cost averaging won't insulate you from losses or guarantee a profit in a volatile market, investors will purchase more shares when prices are lower, and fewer when they are higher. But for dollar-cost averaging to be effective, an investor must continue to make investments in both up and down markets.

2. Consider rebalancing

Assuming you're comfortable with your investment plan, check to see whether your asset mix may have veered off course due to the recent market pullback. If so, consider rebalancing to your target mix. Rebalancing into investments that have lost value during a down market means investors may invest at a lower price.

Consider a quick example. Say Amy (a hypothetical investor) rebalances annually. Imagine that this year, the large-cap portion of her portfolio has declined, and small caps lost even more, while bonds produced smaller losses. Her instinct may be to buy more bonds and avoid buying the losers, but buying the losers is precisely what rebalancing means—buying more small- and large-cap stocks, either by reallocating her investments or putting new money to work.

"The beauty of rebalancing and dollar-cost averaging is that it helps an investor buy low—when investments are effectively on sale—countering our natural tendency to do just the opposite," says Dowd. "Over time, that discipline can pay off."

3. Consider putting your losses on the books

Down markets also provide an opportunity to boost after-tax returns by taking capital losses. This strategy, called tax-loss harvesting, involves selling stocks, bonds, and mutual funds that have lost value to help reduce taxes on realized capital gains from winning investments. If your losses exceed your gains, realized capital losses can be used to offset up to $3,000 of ordinary income each year. Any unused losses can be carried over to future years.

How can an investor take advantage of this opportunity without throwing off an investment strategy? Consider selling investments that no longer fit a strategy, or ones with poor prospects, which an investor may want to sell regardless of the tax impact.

Or, consider looking for investments to sell that can be replaced by similar investments, keeping an overall investment mix on track. But be careful. To qualify for the tax-loss benefit, an asset that is purchased within 30 days of a sale, cannot be "substantially identical" (as defined by the IRS). Remember, tax rules are complex, and you should get more details or talk to a financial planning or tax professional for more information.

"Investors shouldn't let taxes drive their investing decisions, but downturns do provide the potential to record losses, and reduce taxes," says Dowd.

4. Consider a Roth IRA conversion

Roth IRAs have several benefits, including the potential for tax-free withdrawals,* and no required minimum distributions during the lifetime of the original account owner. To qualify to make a contribution, a person must have earned income, and stay under an income limit.

In 2019, if you are married and filing jointly, you must have modified adjusted gross income (MAGI) under $203,000 to contribute up to the limit of $6,000 ($7,000 for those 50 years of age or older). For single filers, your MAGI must be $122,000 or less to qualify for the full contribution. Joint filers with MAGI from $193,000 to $203,000 ($122,000 to $137,000 for singles) are eligible to make reduced contributions.

Don't meet those income requirements? Not to worry. Anyone can convert all or part of a traditional IRA to a Roth IRA as long as they pay income taxes on the money at the time of the conversion. And a market downturn may be a particularly good time to consider a conversion, because the taxation would likely apply to a smaller conversion amount. Investors may want to convert a certain dollar amount, in which case a downturn would allow them to move more shares.

Consider this hypothetical scenario. A couple is married and files jointly and wants to convert as much of their assets as possible to a Roth IRA, while keeping their taxable income under the top of the 12% tax bracket. That tax bracket is capped at $78,950 for 2019. After calculating their taxable income from all other sources, they convert enough from a traditional IRA to hit that limit.

Let's say their taxable income before converting is $73,950, so they can afford to convert $5,000 and remain in the 12% bracket in 2019. Now suppose that before a market downturn, the shares of mutual fund A, held in their traditional IRA, are $10 each. If they convert then, their $5,000 conversion would allow them to move 500 shares into their Roth IRA. But if, after a market downturn, those shares had fallen to $8 each, the same $5,000 conversion would allow them to move 625 shares instead. That effectively lowers the taxes paid for each share converted.

By converting when the market is down, they may be able to help manage their tax bill. Roth conversions are complicated, so consult a professional and seek more information.

The bottom line

An investment strategy is meant to work over the long term through market ups and downs, so investors need to keep a short-term pullback in perspective.

Markets will rise and markets will fall, and with the changes, opportunities will appear. To make the most of a bad market, consider taking advantage of lower-cost investments through a disciplined strategy, while looking to take advantage of the potential tax benefits of a downturn.

Next steps to consider

We can help you create a plan for any kind of market.

Explore how to invest your money and get investing ideas to match your goals.

What to consider doing when the market picture becomes uncertain.

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